Inflation – Concept, Types and Measurement

Inflation – Concept, Types and Measurement

         A rise in the general level of prices in an economy that is sustained over time is known as inflation. When the general level of prices is falling over a period of time, it is known as disinflation or deflation.

 

Causes of Inflation:

Demand –Pull Inflation: When there is a mismatch between demand and supply - either the demand increases over the same level of supply, or the supply decreases with the same level of demand, prices shoot up.

Cost- Push Inflation: The rise in price level as a result of increase in the production cost (cost of labor, raw material) of goods and services in the economy is known as cost push inflation.

 Types of Inflation:

Depending upon the range of increase, and its severity, inflation may be classified in three broad categories:

Low inflation/ creeping inflation:  

• Inflation which is slow and on predictable lines and gradual (takes place for a longer period)
• Price rise at a very small to moderate rate (3% -10%)
• Example: Monthly inflation rate of a country for six months

Galloping inflation/Running or Runaway inflation:

• Inflation which is very high and leads to collapse of the economy
• Price rise at a very high rate (10%-100% or 200%)
• Example: Inflation in Russian economy after the disintegration of ex-USSR

Hyperinflation:

• Inflation which is large and accelerating that takes place in a short span of time
• Price rise at an annual rate in millions or trillions
  
• Example: Inflation in Germany after the First World War

 

Important Terms in inflation:

• Inflationary Gap: Excess of total government spending above national income
• Deflationary Gap: Shortfall in total spending o f the government over the national income
• Inflation Spiral: An inflationary situation in an economy which results out of a process of wage and price interaction – when wages press prices up and prices pull wages up
• Philips Curve: A graphic curve which advocates a inverse relationship between inflation and unemployment in an economy
• Reflation: When the economy is crossing a cycle of recession and government takes some economic policy decisions to revive the economy from recession, certain goods see sudden and temporary increase in their prices, such price rise is known as reflation
• Stagflation: An economic situation where inflation and unemployment both are at higher levels
• Core Inflation: A measure of price rise in the economy based on the inclusion or exclusion of the goods or services
• Skewflation: When there is price rise of one or a small group of commodities over a sustained period of time

Effects of Inflation:

• Inflation redistributes wealth from creditors to debtors
• With the rise in inflation, lending institutions feel the pressure of higher lending
• Rising inflation indicates rising aggregate demand and indicates comparatively lower supply and higher purchasing capacity among the consumers
• Inflation affects the income of individual and firms
• In the long run, higher inflation depletes the saving rate in an economy
• Increases prices make our consumption levels fall as goods and services we buy get costlier
• Inflation makes investment expenditure increase as a result of decreased cost of money
• Inflation increases the nominal value of wages, while their real value falls

Measurement of Inflation:

In general, there are three price index series:

• GDP Deflator 
• Wholesale Price Index – WPI
• Consumer Price Index- CPI
•   CPI for Industrial Workers(CPI-IW)
•   CPI for urban non manual employees(CPI-UNME)
• CPI for agricultural labourers(CPI-AL)
• CPI for rural India(CPI-RI)
•   CPI for urban India(CPI-UI)
•  CPI for rural-urban combined(all India) (CPI-AI)

GDP Deflator:

• Refers to the index of the average price of the final goods and services produced in the economy
• Computed as the ratio of the nominal GDP in a given year to the real GDP of that year

Wholesale Price Index:

Refers to the index of the average price of all commodities produced and /or transacted in the economy at the first point of bulk sales in the domestic market

Consumer Price Index:

Refers to the index of the average retail price of the goods and services contained in the consumption basket of the relevant group of customers.

Various indices yield different rates of inflation because:

• Prices of various items do not always change in the same direction and same proportion
• Prices of some items, like fruits and vegetables, are highly seasonal
• Retail prices are generally more volatile than wholesale prices
• Prices of commodities usually fluctuate more than those of services

 

Base effect:

It refers to the impact of the rise in price level in the previous year over the corresponding rise in price levels in the current year.

Current inflation rate= [(Current Price Index-Last year’s Price Index) /Last year’s Price Index] x 100

 

Measurement of Inflation on Period Basis:

• Annual average inflation rate: It is the average of 52 weeks of inflation date but it could be available at the end of the year.
• Point-to-Point inflation rate: It is measured on the basis of changes taken place between particular week of the year and the same week of the current year. It is available throughout the year.